Submitted by QTR’s Fringe Finance
Friend of Fringe Finance Lawrence Lepard released his most recent investor letter a few days ago with his updated take the Fed, crypto, gold and macro.
Larry has joined me for several interviews over the last year and I believe him to truly be one of the muted voices that the investing community would be better off for considering. He’s the type of voice that gets little coverage in the mainstream media, which, in my opinion, makes him someone worth listening to twice as closely.
Larry was kind enough to allow me to share his most recent thoughts. You can read Part 1 of this letter, released days ago, here.
Crypto And Bitcoin
There was probably no greater poster child for the speculative expansion of this bubble than the enormous growth in the crypto currencies and Bitcoin. From a starting point of only 50 crypto currencies back in 2013, when Bitcoin began to emerge, there are now over 20,000 crypto currencies.
Reliable estimates suggest that the entire crypto market was $3 Trillion at its peak in November of 2021; today it is approximately $866 Billion, or a decrease of 71%. The paper value attributed to these trading vehicles in such a short period of time is stunning; demonstrating that when crowd psychology chases perceived easy wealth it can go much further than expected, yet it always ends badly.
A perfect example is Dogecoin named after a dog and started as a joke, but it caught favor with celebrities and Elon Musk and went on to achieve a peak market valuation of $87.5 Billion before collapsing 90%. Notably it still trades at a $9 Billion market cap which is $9 Billion too much, in our opinion.
Given the unregulated nature of crypto and the rise of many offshore exchanges, there was a lot of leverage being used in this space, and there was also a lot of fraud. Many crypto currencies were built on faulty premises and were nothing more than sophisticated pump and dump schemes. A notable example is Luna/Terra which hawked an algorithmic stable coin that was designed to give investors a 20% annual yield. How they were able to generate these kinds of returns was never specifically explained.
Like Gold, Bitcoin and cryptos do not provide yield. Thus, for any arranged scheme to provide yield, it clearly would imply that lots of leverage was employed. In our low-rate world where money is priced too cheaply, hucksters were bound to show up to sell to the masses.
The fraud that was Luna Terra coin traded at a peak market cap of $18B before a run on the bank caused the entire scam to collapse to worthlessness. This is not the only crypto related entity which has collapsed to worthlessness – Celsius, the hedge fund 3 Arrows Capital, Voyager Digital, and Compass Mining have also collapsed. We believe there is a lot more pain to come.
At the heart of all of this crypto meltdown is “phantom collateral” (i.e., lenders think they have real collateral backing their loan; but alas they don’t, and often the borrower has borrowed from others using the same phantom collateral. Yet, like in musical chairs, when the music stops and loans are called in – collateral either doesn’t exist or multiple parties have claims on the same collateral, or it was worthless to begin with. We saw this in the 2008 housing bubble with Collateralized Debt Obligations (CDO) and CDO squared type scams.
As we saw in this draw down many crypto currency holders also held Bitcoin, and in a leveraged unwind they were forced to dump their Bitcoin on the market.
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Bitcoin Is Not Crypto
It is important to distinguish between Bitcoin and all other crypto currencies. We strongly oppose all other crypto currencies, which when boiled down to it are just a bunch of middlemen trying to take their “toll” on the highway of the blockchain/Bitcoin by playing levered, fiat games.
We strongly believe in Bitcoin, and are what the world calls, Bitcoin maximalists.
Bitcoin is a unique technical invention. It is a software protocol and a network of 10s of 1000s of nodes globally that provides a secure, immutable open ledger (i.e., records can’t be modified). On this network flows a digital currency that is scarce and will continue to get more scarce overtime as the supply of new coins decreases. There will only be 21 million Bitcoin in total issued (19.1 million coins have been issued, thus far).
This scarcity and security are obtained by using a blockchain with a proof of work algorithm which prevents the “double spend” problem. The rules of the network are ironclad, mathematical and could only be changed with consent of 51% of the decentralized network nodes which are spread across the world. No human can mess with the pre-coded software formula, and economic incentives make such a change unlikely. It is just math. Thus, Bitcoin represents, in our view, a digital form of gold or a sound monetary medium that will be the leading form of payment and store of value in the future.
Crypto currencies do not have the characteristics of Bitcoin. Most are based upon a Proof of Stake (POS) model which allows the largest holders to set and change the rules. This is a huge deal because it means that the issuance policies of all other crypto currencies are subject to change by the people at the top of the chain (the leading stakeholders) – meaning they are centralized, not decentralized like Bitcoin.
Take Ethereum for example, it is controlled by a small group and the token supply issuance policy has changed 6 times during its life and counting. We do not trust or believe in any other crypto currencies as a store of value. It is possible that useful good cryptos will emerge, but with 20,000 to choose from we have no idea which ones are likely to succeed. Furthermore, these are likely to emerge with different use cases than secure store of value, which is where Bitcoin excels.
Conversely, we are witnessing consistent growth of the Bitcoin network as many are drawn to the favorable features that we outlined above. As long as adoption and usage continue to grow, when compared to a fixed supply, it is not hard to see what will happen to price. We think it is sad that the frauds and promotion surrounding many crypto currencies have damaged Bitcoin and scared people away from the one true technical development which we strongly believe will succeed over the long run.
The schedule below shows an Elliott Wave technical analysis of Bitcoin since 2016. As we can see, there was an impulse move which launched the coin in late 2020 and now we are in a full- fledged correction. Bitcoin has gone through this cycle several times before at smaller scale.
To review how we have invested in this area, we presently hold roughly 3% of the Fund in the coins and roughly 14% of the Fund in private companies which provide services related to Bitcoin. Even after this draw down in the price of Bitcoin, our cost basis in Bitcoin related investments is $3.9 million and they are currently valued at $7.0 million (roughly 18% of the Fund). So we are well ahead on our Bitcoin investments. We have been adding to our coin holdings at this level because Bitcoin has only been this cheap compared to its 200-day moving average for 3% of the days it has existed.
We expect the price of Bitcoin to find a bottom as we get closer to the Fed pivot. We still maintain that it has the most asymmetric upside of any financial asset in the world. We believe that on the other side of the crypto meltdown, Bitcoin’s strength will grow as it is seen to be the one true crypto currency which represents an innovation and does what it claims to do. Bitcoin will no longer compete with other cryptos, it will have won. Some regulation will be required and indeed will likely be a key catalyst to wider adoptions by institutions.
Monetary Chaos: Inflation or Deflation
Ever since we pivoted the Fund in 2008 to focus on gold and silver mining stocks, and subsequently added Bitcoin to the mix, we have been using the term “monetary chaos” to describe the world we are living in. The Fed’s low interest rate policies and QE have destroyed true price discovery in open markets.
As the chart above shows, the Fed decision to hold interest rates at the zero bound for 7 years, when coupled with massive QE which fueled credit growth, has created an economy that is so distorted that nobody knows what the true value of anything is anymore. The Taylor Rule is a model developed by economist John Taylor which adjusts the FF rate to account for inflation and the GDP output gap. In the past, the Fed has used it to guide policy. The important take away from this chart is that in today’s conditions, the Taylor rule suggests that the FF Rate should be almost 8%, a number which would be devastating to the US economy given the 125% Debt to GDP level.
Of course, the “Everything Bubble” which occurred in all financial assets was not just driven by the Fed, the US Government helped with its programs to spend freely to counter the COVID driven economic downturn. The growth in US Treasury debt over the same time frame has been truly extraordinary and it has accelerated recently.
Looking at the chart above, it is hard for an economist or an investor to answer the question: how does this not end badly? Our society is so leveraged and so addicted to mispriced cheap money that, if the Fed ever decides to seriously increase the cost of capital in order to defend the integrity of the dollar, the resulting deflationary collapse is going to rival or exceed the Great Depression (1929-1940).
A higher cost of capital will collapse all risk asset markets and the negative wealth effect creates a negative feedback doom loop. There will be a mad scramble for dollars and liquidity and prices for everything will plunge. We are seeing the early signs of that rush to dollars in the DXY, the collapse in stock markets, housing demand softening, and used car prices correcting. This is exactly what happened in the 1920’s and 1930’s – the last time the world witnessed the collapse of several sovereign debt bubbles.
There are only two alternatives for the US: Default on the massive debt load or inflate our way out of the mess. Historically, inflation has been the more politically palatable choice.
The Fed’s Actions Will Work…Until Stuff Breaks
Currently, because the inflation problem appears to be the most pressing political issue, the Fed is focused on taming inflation via demand destruction with interest rate hikes and withdrawals of QE (QT). Let’s face it, things were very frothy, and the Fed should’ve started this process well over a year ago. Year over year house prices were up 20% per year. Rent prices year over year were up similarly: 17%. Unemployment is very low and labor is pushing hard for wage increases to counter higher living costs. The crypto market was a cornucopia of speculation and price bubbles.
The problem the Fed will face is that this may not work. Some of the inflation is structural and long term in nature and will only be solved by bringing more supply capacity online. However, adding capacity requires capital investment and they just raised the price of capital. Not what would be necessary to encourage new investments.
The Fed knows that part of the inflation problem is “inflationary expectations”. That is, if people expect inflation, they will spend more quickly thereby creating more demand and driving more inflation. We think this is why the Fed has been so aggressive with its anti-inflation rhetoric and in slowing the y/y money supply growth (see chart below).
So a deflationary impulse has been created as seen in the softening of almost all asset classes. Yet, given the fragility of the levered global system and some of the cracks beginning to emerge (e.g., Japan, Emerging Markets and some Credit Default Swaps), we also think that the Fed is going to be forced to reverse course, and probably fairly quickly. As a very wise investor recently described the Fed’s predicament:
“We are in a period, a temporary period, that will probably last 6 to 12 months of a tightening in monetary policy. But that will be the correction in the trend. That tightness will produce weakness in markets and the economy, to be followed by another round of easing.”
– Ray Dalio, June 2022
Recall that the Fed has two formal mandates (full employment and price stability) and one informal mandate (functioning financial markets). Powell has referred to this third shadow mandate multiple times including during the March 2020 COVID crisis when the US Treasury bond market went no bid. Whereupon he instituted extensive monetary stimulus with a “whatever it takes” policy to keep the Treasury and other markets functioning.
We believe that this short-term deflationary impulse / market correction will be short-lived. It is only a matter of time until something major breaks in the financial markets. As aggressively as the Fed has tightened, it will likely have to stimulate just as aggressively when something breaks. This will lead to even greater monetary debasement.
As one of the wags on Twitter likes to say, you cannot taper a ponzi. In our view, the current deflation is moving quickly, and this reversal will have to happen faster than the market currently anticipates. There are multiple signs that the new “tough guy” Fed policy is creating problems which will force them to pivot. We have seen this movie before from the Fed when QT failed, and a Fed U-Turn was required as the chart below shows.
As the brilliant macro analyst, Luke Gromen, describes it, the Fed thinks they are operating with a dial, but in reality, they have more of a nuclear reactor on/off switch. As Luke stated recently:
“Given that severe bond (and equity) market dysfunction has now begun, before the Fed even officially begins QT, the Fed is left with only a choice of how they want to lose their credibility:
1. Via the stock and bond market crashing before the Fed even starts QT, or;
2. By the Fed stopping tightening and then loosening policy into an inflation spike.”
About Larry Lepard
Larry manages the EMA GARP Fund, a Boston based investment management firm. Their strategy is focused on providing “Monetary Debasement Insurance”. He has 38 years experience and an MBA from Harvard Business School. On Twitter he is @LawrenceLepard Managing Partner and, via email, he is email@example.com
Disclaimer: QTR is long various gold and silver miners and have both long and short exposure to the market through equities and derivatives. I have no position in Larry’s funds. Larry is a subscriber to Fringe Finance and has been on my podcast. The excerpts from Larry’s letter, above, shall not be construed as an offer to sell, or the solicitation of an offer to sell, any securities or services. Any such offering may only be made at the time a qualified investor receives from EMA formal materials describing an offering plus related subscription documentation. There is no guarantee the Fund’s investment strategy will be successful. Investing involves risk, and an investment in the Fund could lose money. The strategy is also subject to the following risks: Currency Risk, Non-US Investment Risks, Issuer Specific Risk.
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